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Using Linear Regression Channels

 

I am currently using Linear Regression Channels in ThinkOrSwim (TOS) to try to time when I should enter my options trades. I have that added into my TOS chart and I am now trying to improve myself using this tool.





Linear Regression Channels are a great way to identify potential key levels of future price action by graphing the normal distribution of a trend. 


Two points on a trend are chosen, generally at the beginning of the trend and the end of the trend. When the two points on the chart are chosen, the normal distribution of the dataset is calculated between the two chosen points and displayed in the form of a linear regression channel.


The center line in this channel is the Linear Regression Line or Mean, and the upper and lower lines are the Upper and Lower standard deviations from the mean as set in the tool’s settings (default settings are +2 and -2 standard deviations from the mean). I usually uuse +1,-1 (50) and +2, +2 (100) in TOS. 


The correlation of this linear relationship is displayed as Pearson’s correlation coefficient , or Pearson’s R. This can be displayed or hidden on the chart by selecting it within the tools style menu.


Pearson’s R shows the strength of the correlation as well as its direction, with values moving between -1 and 1. As Pearson’s R moves further away from zero, the strength of the linear relationship between price and time increases. When using the Regression Trend tool, Pearson’s R will always be set as an absolute value (positive), but the direction of the trend can be visually identified.


Mean reversion

When a regression trend has a high correlation, this is due to the consistency of price action laying along the mean (center line), with fewer points moving above and below the mean line to the upper and lower standard deviation levels.


One way to trade using a linear regression channel is to trade the price action as it moves away from, and back to the mean.


As this tool is used, it is important to note that a channel graphed containing more bars and having a high correlation is more likely to have price continue in that trend than one that is graphed with only a few bars and having a high correlation.


The length of the trend should be considered when trading these channels.

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